investor s guide ZERO COUPON MUNICIPAL BONDS

Transcription

1 investor s guide ZERO COUPON MUNICIPAL BONDS

2 CONTENTS Introduction 1 Understanding the Municipal Market 2 What are Zero Coupon Bonds? 3 Characteristics of Zero Coupon Municipal Bonds 3 Variations of Zero Coupon Municipal Bonds 6 Assessing Risk 7 Investment Strategy Considerations 10 Are Zero Coupon Municipal Bonds for You? 11 Tax-Exempt/Taxable Yield Equivalents 11 State Taxation of Municipal Bonds for Individuals 14 State Taxation of Municipal Bonds for Corporations 15 Glossary 16 All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association (SIFMA) from our membership and other sources believed by SIFMA to be accurate and reliable. By providing this general information, SIFMA is neither recommending investing in securities, nor providing investment advice for any investor. Due to rapidly changing market conditions and the complexity of investment decisions, please consult your investment advisor regarding investment decisions.

3 INTRODUCTION Types of Zero Coupon Bonds The three largest categories of zero coupon securities available are zero coupon Treasury bonds, zero coupon corporate bonds and zero coupon municipal bonds, which are issued by the U.S. Treasury, corporations, and state and local government jurisdictions, respectively. Generally, zero coupon Treasury bonds are considered the safest zero coupon bonds because they are backed by the full faith and credit of the U.S. government. Zero coupon corporate bonds and municipal bonds offer a potentially higher rate of return commensurate with additional credit risk, which will vary based on the issuing entity. Zero coupon municipal bonds are the only zero coupon securities that pay interest that is exempt from federal income tax and, in many cases, state and local taxes. This guide will discuss zero coupon municipal bonds. Size of the Municipal Zero Coupon Market Zero coupon bonds were introduced to the fixedincome market in The municipal zero coupon market is substantially larger today than it was in 1982, when there were 58 new offerings totaling $2.2 billion in issuance. In 2009, there were 380 new issues totaling $17.2 billion. More than billion of zero coupon municipal bonds have been issued in the past ten years.* To understand how zero coupon municipal bonds work, it is important first to become acquainted with the principal characteristics of both municipal bonds and the zero coupon structure. * Source: Thomson Reuters 1

4 UNDERSTANDING THE MUNICIPAL BOND MARKET Municipal bonds are the debt obligations of states, their political subdivisions and certain agencies and authorities. The municipal bond market is one of our nation s most remarkable financial institutions, providing a mechanism whereby more than 50,000 state and local government units can raise money for public purposes such as water and sewer systems, schools, highways and public buildings. Under present federal income tax law, the interest income from most municipal bonds is exempt from federal income taxes. 1 In most states, interest income received from bonds issued by governmental units within the investor s own state is also exempt from state and local income taxes (see table on page 14). Interest income from bonds issued by U.S. territories and possessions is exempt from federal, state and local income taxes in all 50 states as well. In addition to offering tax advantages, municipal bonds have historically low default rates. In the past 50 years, less than one percent of the hundreds of thousands of municipal bonds issued have gone into default. Individual ownership of municipal bonds, has grown from approximately $130 billion in 1980 to $978 billion at the end of For more detailed information on municipal securities, you may want to ask your account representative for a copy of An Investor s Guide to Municipal Bonds, available from the Securities Industry and Financial Markets Association (SIFMA). 1 If you are subject to the alternative minimum tax (known as AMT), you may need to include interest income from certain municipal bonds in calculating your income tax. 2

5 WHAT ARE ZERO COUPON BONDS? While most municipal bonds provide semiannual interest payments, zero coupon bonds, as their name suggests, have no coupon or periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds are sold at a substantial discount from the face amount. For example, a bond with a face amount of $20,000, maturing in 20 years with a 5.5% coupon, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,757 represents the interest that compounds automatically until the bond matures (see example on the next page). CHARACTERISTICS OF ZERO COUPON MUNICIPAL BONDS Zero coupon municipal bonds combine the benefits of the zero coupon instrument with those of taxexempt municipal securities and offer the following advantages: Tax Benefits Because the interest paid by zero coupon municipal bonds is exempt from federal income taxes, these bonds provide returns that are often much higher on a net basis than comparable taxable securities. To see what a difference tax-exempt interest can make, turn to the Tax-Exempt/Taxable Yield Equivalents table on pages 12 and 13. 3

6 ESTIMATED FUTURE VALUE OF A 20-YEAR 5.5% ZERO COUPON MUNICIPAL $6, PURCHASE $20,000 $15,000 $10,000 $5, Example: A $6, purchase of zero coupon municipal bonds on January 1, 2008, due January 1, 2028, with a 5.5% original-issue yield and semi-annual compounding will be redeemed in 20 years for $20,000. The purchase will accrete as shown below on January 1 of each of the following years: 2013 $ 8, $ 11, $ 15, $ 20,

7 Further, tax-exempt zero coupon municipal bonds earn interest that, in many cases, is also free from state and local taxes. (Certain out-of-state municipal bonds may be taxable at the state level. Check with your tax attorney or advisor.) In contrast, taxable zero coupon bonds are taxed each year on the amount of interest that has accrued for that year even though the accrued interest is not paid to investors in that year. If an investor sells a zero coupon municipal bond at a price that is higher or lower than the price at which it was purchased then, like any other fixed income investment, there is a possibility of capital gain or loss. Low Minimum Investment Typically, zero coupon municipal bonds are sold in denominations of $5,000 face amounts. Because they are sold at a substantial discount from face amount, you can purchase more zero coupon bonds for your money than other types of bonds. The greater the number of years a zero coupon bond has until maturity, the less you have to pay for it. Zero coupon bonds allow investors to invest a modest amount of money today and know exactly how much money they will receive on a specified future date. Protection from Reinvestment Risk Zero coupon municipal bonds provide investors with the opportunity to lock in a particular rate of return, without having to worry about reinvestment risk or interest rates in the future. Investors in securities that pay interest semiannually may not always achieve a total realized compounded yield equal to the quoted yield to maturity they expected when they purchased their holdings. Depending on future prevailing interest rates, their interest payments may be reinvested in lower or higher yielding vehicles. 5

8 Maturity Zero coupon municipal bonds offer a wide choice of bonds. There are zero coupon municipal bonds available with maturities ranging from one to 40 years, with the majority of these bonds having maturities between eight and 20 years. Credit Quality The majority of zero coupon municipal bonds are rated A or better by the three major rating services: Moody s Investors Service, Standard & Poor s and Fitch Ratings (see Assessing Risk on page 7). Some zero coupon municipal bonds carry insurance and are rated AAA. Credit ratings, however, should not be the sole basis for any investment decision. Liquidity If you want to sell your zero coupon bonds before they mature, you may do so in the secondary market at prevailing market prices (see Market Risk on page 8). VARIATIONS OF ZERO COUPON MUNICIPAL BONDS Two common variations of zero coupon municipal bonds are convertible zero coupon municipal bonds and stripped municipals. Convertible Zero Coupon Municipal Bonds These bonds are sold as zero coupon municipal bonds and then, generally after eight to 15 years, convert to interest-paying bonds. They can be used by individuals planning for retirement. During their working years, individuals can accumulate tax free capital that is ready for them when they retire. Then, upon retirement, they can receive the tax free income stream they need for living expenses. 6

9 Stripped Municipals Municipal bonds which pay interest semiannually can be separated (or stripped) into their principal and the interest components. The cash flow of the coupons is repackaged into stripped municipals with a greater variety of maturities from six months to 40 years. Like zeros, stripped municipals are issued at a deep discount from face value and are available in a wide range of credit qualities. ASSESSING RISK Credit Risk You should assess the creditworthiness of a zero coupon municipal bond the same way you would any municipal bond. Doing so is particularly important for zero coupon bonds since all your principal investment returns are paid at maturity. For municipal bonds, credit risk is determined by the financial and operating stability of the state or local government entity that issued the bond or the entity that is obligated to pay the principal of and interest on the bonds. Virtually all new issues of municipal securities are originally offered by means of disclosure documents (called official statements or offering circulars) that describe in detail the financial condition of the issuer or the entity responsible for making payments on the bonds. From these disclosure documents, which are available through the Municipal Securities Rulemaking Board s Electronic Municipal Market Access portal at investors can determine the risks involved in the investment. In assessing the relative quality of zero coupon municipal bonds, investors may consider the ratings provided by one or more of the three major rating agencies, which have established the following classifications: 7

10 CREDIT RATINGS MOODY S STANDARD & POOR S FITCH NON-INVESTMENT GRADE INVESTMENT GRADE Strongest Aaa AAA AAA Aa AA AA A A A Baa BBB BBB Ba BB BB B B B Caa CCC CCC Ca CC CC C C C Weakest C D D Generally, bonds that are rated at least BBB or Baa by Standard & Poor s and Fitch Ratings or Moody s, respectively, are considered to be investment grade, or suitable for preservation of invested capital. Bonds with lower ratings indicate a higher degree of risk. The rating agencies grade bonds according to their investment qualities but do not intend the rating to be the sole basis for an investment decision. The ratings cannot, for example, forecast market trends. Before purchasing any bonds, particularly those with lower ratings, talk with your investment advisor to make sure they are suited for you. Market Risk As with all fixed-income securities, the yields or interest rates on zero coupon municipal bonds fluctuate, usually in step with general market rates. While the interest on a bond is fixed by the price you paid, newer bond issues may be offered at higher or lower interest rates depending on prevailing interest rates when they are issued. Like other bonds, the values of zero coupon municipal bonds move inversely to the movement of interest rates: bond values will increase as interest rates decline, and bond values will decrease as interest 8

11 rates increase. As a result, zero coupon municipal bonds that were purchased when interest rates were higher and sold in the secondary market when interest rates are lower will generate capital gains. Conversely, investors who sell their bonds during periods of rising interest rates will incur capital losses. Zero coupon bonds are more sensitive to interest rate swings than bonds which pay interest semiannually because all the interest payments of zero coupon bonds are accumulated and paid at maturity. A coupon bond which pays interest semiannually loses its volatility as it draws closer to maturity because its true value to investors interest slowly dwindles as the number of interest payments left declines. The longer the maturity of a bond, the greater its volatility. Call Provisions Many municipal bond issues allow the issuer to call (or redeem) all or a portion of the bonds at a premium or at par before maturity. When investors purchase bonds, dealers will quote the yield to the call date if it is less than the yield to maturity. Therefore, an investor can know what the return on the bond will be if the issuer exercises its right to call the bonds. Typically, zero coupon municipal bonds containing call provisions provide that the bonds may be called at the option of the issuer on a specific date at a price or premium based on the accreted value of the security that was established at the time of issuance (known as the original accretion rate). Before purchasing state and local bonds which are subject to special redemption provisions as well as bonds that contain sinking funds, you should pay careful attention to the call provisions. In addition, investors purchasing bonds at a premium in the new issue or secondary market should use care when paying prices in excess of an issue s original accretion rate because a call may result in a lower than expected yield or even a loss. 9

12 INVESTMENT STRATEGY CONSIDERATIONS Zero coupon municipal bonds offer certain tax advantages and are often attractive to investors seeking long-term capital accumulation for retirement, education funding or other long-range savings goals. Individuals can time the maturity of their investment to match their future needs. Retirement planning Zero coupon municipal bonds can be used to supplement a retirement savings program. They are not, however, typically suitable for Individual Retirement Accounts (IRAs) or qualified pension plans because these plans already have tax advantaged status. Education funding A municipal zero portfolio can be structured to mature during a child s or grandchild s college years. Gifting Assets given today under the annual estate and gift-tax exclusion of $13,000 per person can continue to grow with the tax benefits of zero coupon municipal bonds. Kiddie tax Since passage of the Tax Reform Act of 1986, Uniform Gift to Minors Accounts generating more than $1,800 in annual income for minors under the age of 18 are taxed at the parents or guardians rates. 10

13 ARE ZERO COUPON MUNICIPAL BONDS FOR YOU? Now that you are acquainted with some of the principal characteristics of zero coupon municipal bonds, you should review your investment portfolio with your financial advisor to determine whether it provides the degree of safety and long-term growth potential offered by zero coupon municipal bonds. Your financial advisor can answer your questions about specific zero coupon municipal bonds and help you define your investment objectives. These professionals can provide you with information about current offerings in both the new issue and secondary markets and can assist you in selecting the bonds most suited to your needs. TAX-EXEMPT/TAXABLE YIELD EQUIVALENTS The table that begins on the following page will help you determine the amount of income you require from a taxable investment to equal the yield on a tax-exempt bond. The table is for illustrative purposes only and is not intended to be representative of any specific security. To use the table most effectively, follow the directions in italics at the left side of the chart. A version of this yield calculator is also available at 11

14 TAX-EXEMPT/TAXABLE 2010 HOW TO USE THIS CHART 1. Find the appropriate return (single or joint). 2. Determine your tax bracket by locating the taxable income category that you fall into. Taxable income is income after appropriate exemptions and deductions are taken. (The table does not account for special provisions affecting federal tax rates, such as the Alternative Minimum Tax.) 3. The numbers in the column under your tax bracket give you the approximate taxable yield equivalent for each of the tax-exempt yields in the near left column. Example: If you are single and have a taxable income of $85,000 ($140,000 if married), you would fall into the 28% tax bracket. According to the table, you would need to earn 6.94% on a taxable security to match a 5% yield from a tax-exempt security. SINGLE $0- RETURN $8,375 JOINT $0- RETURN $16,750 TAX BRACKET 10% TAX-EXEMPT YIELDS (%) 1.0% 1.11% * The income brackets to which the tax rates apply are adjusted annually for inflation. Those listed above are for

15 YIELD EQUIVALENTS TAX YEAR TAXABLE INCOME* $8,376 $34,001 $82,401 $171,851 $373,651 $34,000 $82,400 $171,850 $373,650 & OVER $16,751 $68,001 $137,301 $209,250 $373,651 $68,000 $137,300 $209,250 $373,650 & OVER 15% 25% 28% 33% 35% TAXABLE YIELD EQUIVALENTS (%) 1.18% 1.33% 1.39% 1.49% 1.54%

16 STATE TAXATION OF MUNICIPAL BONDS FOR INDIVIDUALS STATE S OTHER OWN STATES STATE BONDS BONDS Alabama... X Alaska (no tax)... Arizona... X Arkansas... X California Income... X Colorado... X Connecticut... X Delaware... X District of Columbia... Florida... Georgia... X Hawaii... X Idaho... X Illinois... X(2)... X(2) Indiana... Iowa... X(2)... X Kansas... X Kentucky... X Louisiana... X Maine... X Maryland... X Massachusetts... X Michigan... X Minnesota... X Mississippi... X Missouri... X Montana... X Nebraska... X Nevada (no tax)... New Hampshire... X New Jersey... X New Mexico... X New York... X North Carolina... X North Dakota... X(3) Ohio... X Oklahoma... X(4)... X(4) Oregon... X Pennsylvania... X Rhode Island... X South Carolina... X South Dakota (no tax)... Tennessee... X Texas (no tax)... Utah... X(2)... X(1)(2) Vermont... X Virginia... X Washington (no tax)... West Virginia... X Wisconsin... X(2)... X(2) Wyoming (no tax)... Bonds are designated X if taxable. All others are exempt or excluded from tax, or no income taxes are levied by those states. In certain cases, these designations pertain only to general obligation bonds, or to bonds in general. For example, a state may not generally exempt bonds, but some bonds may be specifically exempted by the laws authorizing their issuance. (1) Income earned from a bond issued by another state is taxable only if such other state imposes a tax on Utah bonds. (2) Interest from some obligations is exempt from tax. (3) Taxable only if long form is used. (4) Some bonds may be exempt by state law. 14

17 STATE TAXATION OF MUNICIPAL BONDS FOR CORPORATIONS STATE S OTHER OWN STATES STATE BONDS BONDS Alabama... X Alaska (no tax)... Arizona... X Arkansas... X California Franchise... X... X California Income... X Colorado... X Connecticut... X... X(5) Delaware... X District of Columbia... X Florida... X... X Georgia... X Hawaii... X Idaho... X Illinois... X(6)... X(6) Indiana... X(7) Iowa... X(6)... X Kansas... X Kentucky... X Louisiana... Maine... X Maryland... X Massachusetts... X... X Michigan... X Minnesota... X... X Mississippi... X Missouri... X Montana... X(6)... X Nebraska... X Nevada (no tax)... New Hampshire... New Jersey... X... X New Mexico... X New York (8)... X... X North Carolina... X North Dakota... X Ohio... Oklahoma... X(6)... X Oregon... X Pennsylvania... Rhode Island... X South Carolina... X South Dakota... X... X Tennessee... X... X Texas... Utah... X... X Vermont... X Virginia... X Washington (no tax)... West Virginia... X(5)... X Wisconsin... X(6)... X Wyoming (no tax)... (5) Pro-rata adjustment is allowed. (6) Interest on some obligations is exempt by law. (7) Taxable only for gross income tax purposes. (8) Interest on U.S. obligations and obligations of all states would not be taxable if the investment allocation percentage is zero. Otherwise, the interest is taxable at the investment allocation percentage. Source: Reproduced with permission from State Tax Guide, published and copyrighted by Commerce Clearing House, Inc., 4025 W. Peterson Ave., Chicago, Illinois Reflects law through 1/1/10. 15

18 GLOSSARY Accreted value: The current value of a zero coupon municipal bond, taking into account interest that has been accumulating and automatically reinvested in the bond. Bond: A promise to pay the principal amount plus interest due on a specific date. Callable bonds: Bonds that are redeemable prior to the specified maturity date at a specified price at or above par (or at or above their accreted value, for zero coupon bonds). Default: Failure to pay principal or interest when due. Discount: The amount by which the purchase price of a bond is less than the principal amount or par value. In the case of a zero coupon bond, a discount is measured from the accreted value based on the original issuance. Double and triple tax-exemption: Securities that are exempt from state and local taxes or state, local and federal income taxes are said to have double tax exemption or triple tax exemption, respectively. Interest: Compensation paid or to be paid for the use of money, generally expressed as an annual percentage rate. Issuer: A state, political subdivision, agency or authority that borrows money through the sale of bonds or notes. Marketability: A measure of the ease with which a security can be sold. Maturity: The date when the face amount of a bond becomes due and payable. Original issue discount bond: A bond issued at a price less than par which qualifies for special treatment under federal tax law. Un der that law, the difference between the issue price and par value to be treated as taxexempt income rather than capital gain if the bonds are held to maturity. Par value: The principal amount or face amount of a bond or note due at maturity. Principal: The face amount of a bon, exclusive of accrued interest and payable at maturity. 16

19 Redemption premium: In the case of zero coupon bonds, the amount by which the call price exceeds the accreted value. Secondary market: The market for issues previously offered or sold. There are more than 2,040 banks and brokerage firms across the country that are registered to sell municipal bonds. An estimated $19.4 billion in municipal bonds are traded daily in the secondary market. Zero coupon bond: A bond for which no periodic interest payments are made. The investor receives one payment at maturity, equal to the principal invested plus interest earned, compounded semiannually, at the original interest rate to maturity. New York Washington Copyright All reproduction and other rights reserved. 17

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